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Weekday Trader

First American May Slip When Refis Fade

By

Allison Krampf

June 10, 2003 6:46 p.m. ET

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FIRST AMERICAN CORP. HAS benefited from the American dream of owning one's own home -- especially lately, as interest rates dropped to multiyear lows and mortgage applications soared.

First American
is the number-two provider of title insurance, behind market leader Fidelity National Financial. Title insurance protects homebuyers from such unexpected problems as liens against properties.

At A Glance

First American Corp. (FAF)

Stock Price:

$26.35

52-Wk High:

$28.04

52-Wk Low:

$16.14

Market Cap:

$2 Billion

Earnings Est. (2003):

$3.22

Forward P/E:

8.2x

Projected Long-term EPS Growth:

12%

Projected EPS Growth ('03/'02):

10%

Sales (12 mos. through 03/03):

$5 Billion

Div. Yield:

1.57%

CEO:

Parker Kennedy

Headquarters:

Santa Ana, California

Source: Thomson Financial/First Call, Yahoo! Finance

Shares of both title insurers are up smartly since Barron's Online gave them a favorable nod last fall (see Weekday Trader, "Refi Boom Should Be Boon for Title Insurers," September 25, 2002). First American is near its 52-week high, having gained a whopping 63% since it hit a 52-week low last July.

That's all because of those rock-bottom interest rates, which are fueling record mortgage originations and refinancings.

But First American's stock may now fully reflect the benefits of the mortgage boom, which, like all good things, must eventually end. Absent corrosive deflation, it's hard to see how mortgage rates will fall much further. A slow, steady economic recovery also would slow refinancings, from which the company derives 40% of its revenues and earnings.

And First American's efforts to diversify away from title insurance may not gain traction in time to counteract the effects of slowing mortgage volumes. And the stock is no longer cheap.

"I figure they have another quarter or two of earnings visibility, as 85% of total current mortgages" are eligible for refinancing, says Sung Chung, senior analyst with TCW Cowen Asset Management. But in the coming months, Sung, who has been selling First American shares, thinks the mortgage boom will slow.

First American did have an impressive first quarter, beating the consensus earnings per share estimate by eight cents when it reported a 96-cent-per-share profit (net of a one-time gain) in April.

But Wall Street doesn't expect the growth to last: Analysts look for earnings to nosedive by almost 40% in 2004, according to Thomson First Call.

That, along with a projected 28% drop in revenue, prompted portfolio manager Dan Kenady of the Riverfront Small Company Select Fund to pare his fund's position in First American.

"The fact is, there have been so many refinancings, it is hard to conceive of the trend sustaining itself at current levels," Kenady says.

The Mortgage Bankers Association of America's refinance index hit a new high for the week ending May 30, and the MBAA expects both mortgage originations and refinancings to rack up a third straight record-setting year.

Parker Kennedy, First American's president and chief executive officer, concedes that "if refis go away, there is no question that will hurt revenues."

And such a slowdown is likely. Even though bond investors are looking for the Federal Open Market Committee to cut short-term interest rates by at least one-quarter point when it meets June 24-25 (see Current Yield, "One More Time," June 9), Chung doubts that borrowers are ready to take on that much more mortgage debt.

"Once people who have not yet refinanced do so (after the next rate cut), there will be [fewer] potential customers," he says.

The upshot: "Insurance refi-[type] products were a growth story" at the outset of the mortgage boom, but that is no longer the case, Kenady claims.

CEO Kennedy tells Barron's Online that First American has other businesses that could pick up the slack when refis slow. "We have a lot of things that can moderate a (refinance) downturn...," he says. They include First American's profitable default management solutions business.

When interest rates rise, so do defaults, "since people are less able to pay their mortgages," Kennedy explains. First American helps mortgage servicers and lenders handle the extra documentation that comes with defaults. But it's a small unit that's part of First American's Information Technology division, which accounted for 22.5% of revenues last year.

Meanwhile, First American hasn't grown market share recently, Kennedy acknowledges. In 2002, it had 23% of the title insurance market -- about what it had the previous year.

Yet the stock, at 13.5 times next year's estimated earnings, trades above its projected long-term annual earnings growth rate, according to Thomson First Call (see At a Glance).

The shares also change hands at around its median P/E of 9.6x forward earnings for the last five years, according to Thomson Baseline.

The stock's valuation and nice run caused Keefe, Bruyette & Woods to downgrade FAF to Market Perform from Outperform on April 28. Fox-Pitt Kelton also downgraded the stock that day, to In-Line from Outperform.

The mortgage market has fooled investors before. Record-setting originations and refis were supposed to end last year, and yet they keep on rolling. "Things could stay strong, and the Street could be wrong," says Kenaday.

But no rally goes on forever, and this one, too, will pass. That's why investors are looking for stocks whose companies are near the beginning of their strong up cycles, not the tail end.

Full Disclosure

TCW Cowen Asset Management holds roughly 500,000 shares of First American and has been trimming its position lately, says Sung Chung, analyst.

The $5.3 million Riverfront Small Company Select Fund has a 1.7% position in First American and has been selling shares, says Dan Kenady, portfolio manager.

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